The author is a Forbes contributor. The opinions expressed are those of the writer.

Loading ...

Loading ...

This story appears in the {{article.article.magazine.pretty_date}} issue of {{article.article.magazine.pubName}}. Subscribe

Image via CrunchBase

As Northrop Grumman Chairman & CEO Wes Bush completes his third year at the helm of the storied military contractor, he has good reason to be satisfied with what he has accomplished. Although all of the big defense companies are seeing a softening in sales to the Pentagon as overseas wars wind down and Washington moves to rein in deficits, Bush seems to have found a formula for keeping investors happy in hard times.

That didn't look likely when Bush became CEO in January of 2010, because Northrop Grumman had been an also-ran in the post-9/11 defense buildup that repeatedly disappointed investors with unpleasant surprises originating mainly in its naval shipbuilding unit. Bush thus inherited an under-performing enterprise and a restive board of directors at precisely the moment when the outlook for defense contractors was beginning to weaken.

However, the famously analytic Bush -- he was trained as a systems engineer at M.I.T. -- saw what many industry observers did not: that Northrop Grumman was actually very well positioned going forward if it simply paid more attention to the needs of investors. So he got rid of the shipbuilding operation, pulled out of white-space initiatives that looked unlikely to generate profits anytime soon, and moved the corporate headquarters from L.A. to Northern Virginia, only a few miles from the Pentagon and key intelligence-community customers.

Once the low-margin, high-headache businesses were gone, Bush then focused in on lines capable of sustaining strong margins in a defense downturn. Northrop Grumman has quite a few of them, but they're hard for outsiders to understand because some of the most lucrative are either secret or they involve selling equipment to prime contractors rather than the government. For instance, Northrop is by far the biggest subcontractor on the $400 billion F-35 fighter program, providing about a fifth of the content on each plane, and it is uniquely situated in the black world of billion-dollar spy satellites.

Good luck on getting company officials to discuss that last item. It's a big money-maker, but nobody at the company ever discusses in public what Northrop does in its "restricted" space programs -- a business that Bush ended up running after he came to Northrop Grumman as a result of its TRW acquisition in 2002. The company is similarly discreet about the leading role it plays in electronic warfare and cybersecurity, market segments that are expected to hold up well even in a downturn.

With so much of his business off of the table for public discussion, Wes Bush knew company financials had to be strong if investors were to remain engaged in a shrinking defense market. Rather than following the lead of competitors into foreign and commercial markets, Bush focused mainly on delivering the most investor-friendly financial results in the defense sector, combining strong margins in each operating segment with hefty stock buy-backs so that earnings per share and dividends could rise despite static sales.

So whereas the company's overall operating margin was below 9% during the last year of his predecessor's tenure, it rose to 11% in 2010 under Bush and then zoomed up to 14.5% in 2011 following spinoff of the shipbuilding unit. It probably will remain at that level in 2012 and beyond. Meanwhile, the dividend has risen every year of Bush's tenure and currently yields above 3%, a powerful inducement to investors who are facing a depressed interest-rate environment. It is no coincidence this was accomplished as the company was continuously buying back shares, reducing the number of shares outstanding from over 300 million when Bush became CEO to fewer than 250 million today.

Unlike seeking new opportunities in non-traditional markets, this approach delivers results to investors quickly, and sector analysts have begun to notice. ValueLine's Robert Harrington recently described Northrop Grumman as "a rock-solid long-term offering," citing the company's "diversified product lineup and stellar ratings, such as an A++ for Financial Strength and a top-notch Safety rank." The Street rated Northrop Grumman as a "buy" on December 4, describing "its largely solid financial position with reasonable debt levels by most measures, attractive valuation levels, notable return on equity and solid stock price performance."

The term "solid" seems to come up a lot in analyst assessments of Northrop Grumman, which is testament to the skill with which Wes Bush has managed the company's finances. Having served successively as the company's CFO, COO and CEO after leaving the space position, he probably understands the company's businesses better than any other person. And it shows: Bush manages to make his public appearances look effortless, combining a clear presentation style with a seemingly endless grasp of detail.

Of course, not everyone thinks now is the time to be invested in defense companies like Northrop Grumman. With 90% of the company's revenues dependent on the U.S. government, it's easy to see why all the talk of budget sequestration and gridlock in Washington might spook some investors. However, fears about the future can be largely allayed by understanding the dynamics of sequestration and how Northrop Grumman is positioned in the marketplace.

With regard to sequestration, last year's Budget Control Act would likely result in a 13% cut of budget authority in the defense accounts from which Northrop Grumman generates most of its revenues and returns, beginning this fiscal year. That sounds like a big cut, but most of the budget authority for weapon programs typically is not expended in the first year it is approved, so at any given time the programs are being funded largely through prior-year authorizations. In other words, the impact of sequestration will only be felt gradually over a period of several years, producing a 3-4% reduction in outlays in 2013. Northrop Grumman has already demonstrated it is capable of maintaining or improving E.P.S. in the face of such reductions.

With regard to market positioning, Northrop Grumman has fashioned a portfolio of forward-looking technology franchises that is likely to enjoy sustained demand despite pending budget cuts. The company is not heavily exposed to demand generated by overseas military contingencies, and it is not engaged in the metal-bending segments of the defense market such as armored vehicles and ship construction that have recently seen cuts. Its short-cycle technical services business may be impacted sooner than its technology lines by any decline in Pentagon spending, but that business generates only about 12% of corporate revenues.

At the product level, it would be hard to exaggerate how strongly positioned Northrop Grumman is. No other company in the sector can match its experience in signals intelligence, electronic warfare, electro-optical sensors, airborne radars, remotely-piloted vehicles and cybersecurity. It is also unsurpassed in its system-integration skills, which will be a key discriminator going forward as these and other domains must be combined in comprehensive security solutions. Without going into a lot of touchy details, suffice it to say that Wes Bush has fashioned an enterprise likely to do just fine in the years ahead, even as some of his competitors steadily lose altitude.